How to Understand the Difference between APR and APY

/ BY / Credit Cards

Credit cards and interest go hand in hand. However, there are actually different ways of describing the interest you pay, and it’s a difference that you need to be aware of. APR (Annual percentage rate) and APY (Annual percentage yield) are both related to loan and credit card interest rates, but they are two different things that can have a big impact on the overall amount you pay. 

What is Compounding?

Credit card interest rates are quoted to you in the form of an APR, while the interest you earn on savings account deposits is described using the APY. Understanding the difference has to do with the way interest is compounded and reported to you. Compounding is interest paid on interest. To see compound interest in action, let’s say you deposit $1000 into a savings account that pays 5% interest, compounded monthly. The math isn’t too hard as long as you take it step by step:

  • First, multiply $1,000 by .05 which equals $50
  • Second, divide the $50 by 12, the number of months in a year, which equals $4.17
  • Third, add $4.17 to your original balance of $1000, which equals $1,004.17

Instead of the $1,000 you had at the beginning of the month, you now have $1,004.17. Each month the same formula is applied and your balance begins to grow because the balance used in the calculation has grown. Albert Einstein called compound interest “the eighth wonder of the world” because it can be a money tree for investors.

Unfortunately, compounding works against you as a debtor because your creditor uses this formula to determine your monthly balance. Instead of a balance of $1,000, you will owe $1,004.17 after the first month. Only a low interest credit card from years ago would charge 5%. Average credit card interest rates are near 15%, making your first month’s balance closer to $1,012.50. If you don’t pay off your credit card balance each month, your credit card company will earn a lot of interest.

Figuring Interest Charges the APR Way

The law requires lenders to describe the interest rate you pay by using the APR. The formula they use to arrive at the APRis a simple calculation that describes how much interest you will pay in a year. They multiply your interest rate by your balance, divide the product by 12, and add the quotient to the original balance.

This calculation does not reflect how much extra you will pay because of compounding. You will actually end up paying more than this formula predicts.

Figuring Interest Charges the APY Way

The formula to calculate the APY is more complicated because it takes compounding into account, but the APY gives you a much more accurate idea of how much you will pay in interest. The more often your credit card company figures your interest charge, the more money you will end up paying in interest. For example, a credit card with an APR of 9% has an APY of 9.2% if the interest is compounded semi-annually, 9.3% if compounded quarterly, and 9.38 if your credit card company compounds interest monthly. It’s easy to see why a 0 interest credit card can save you lots of money.

Understanding the difference between the APR and the APY can help you understand how much interest you will pay when you carry a credit card balance from month to month. One of the best ways to avoid high interest charges is to pay off your balance monthly.

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